Quarterly Investment Letter 1st Quarter 2019
Market and Economic Review
In a reversal from the sharp downturn in Q4 2018, prices for riskier assets posted substantial gains during Q1 2019. Global equity markets rallied, with the US leading the way. High-yield corporate bonds and commodities also rebounded. Financial markets responded favorably to the US Federal Reserveâs shift away from its monetary tightening bias. In the bond market, the 10-year Treasury bond yields fell below 3-month Treasuries, inverting the yield curve. Curve inversions have preceded the past seven recessions and may be interpreted as a signal of weaker expectations relative to current conditions. Globally, government bond yields continued to decline, with 10-year yields in Germany and Japan revisiting negative territory. A flatter yield curve has challenged banksâ profitability by shrinking the gap between lending rates and funding costs, leading to tighter credit standards in some loan categories.
US workers continue to reenter the labor force amid cyclically low unemployment rates. Tight labor markets have spurred accelerating wage growth, which is typical during late cycle economies and provides support to US consumer spending, but this also can increase inflation. A rising number of US states are reporting higher initial unemployment claims, which may be an early sign of peaking employment growth. Recent weakness in housing activity also is consistent with late-cycle trends.
Global growth remains positive but has become more uneven, and many major economies have progressed toward more advanced stages of the business cycle. Leading economic indicators continue to point to global headwinds. China's growth recession weighed on industrial sectors in Europe and other export economies, but policy stimulus in China appears to have begun stabilizing their growth trajectory. Investors remained hopeful for a US-China trade deal that could deliver near-term relief from tariff escalation. However, a budding geopolitical rivalry may make a variety of other bilateral commercial issues less tractable, particularly strategic competition in the technology sector.
For the past 8 weeks, the worldâs equity markets have moved up unabated from their 52 week low in December. A move such as this has occurred only one other time in history, during the bear market of 2002. In that case, it was a precursor to additional declines. As we formulate our investment strategy, we assess and weigh a multitude of evidence, historical examples, and current statistics. We expound on some of these factors in this quarterâs letter.
Howard Marks, the highly-regarded co-chairman of Oak Tree Capital, is quoted as saying, âIn general, as investors, we canât predict where weâre going, but we should be able to tell where we are. We can do that by âtaking the temperature of the marketâ through questions like: Where does market psychology stand? To what extent has this psychology been priced in? Are attitudes toward risk prudent or cavalier? Answering these types of questions doesnât help predict the future, but it does help investors get the odds on their side because they are better able to determine whether markets are more exposed to upside potential or downside risk.â
With a portion of our stock strategy, we monitor the âmarket temperatureâ to determine how much risk to take. In taking the temperature of todayâs markets, we conclude the math of historical comparisons is flashing a warning sign, for example, consider the chart below. Beginning last October and peaking in December, the fear of losing money became the dominant motivator among investors as the US market declined quickly. That fear has now, once again, given way to a fear of missing out. Within the framework of our overall philosophy, we keep a segment of our funds allocated to stocks invested at all times; ignoring valuations and concerns for the sake of capturing the marketâs long-term average return. However, with other strategies, we actively make shifts in our allocation, not as a prediction of the future, but as an acknowledgment that there are times when risk is more elevated than others. Accordingly, we are presently holding additional cash due to overall market conditions. Despite adjustments, if the market declines we expect to decline, and if the market increases we expect to increase, but we expect our fluctuation to be somewhat dampened in either direction. We feel this is the most rational approach in light of potentially high stock valuations, slowing global growth, low interest rates, high debt levels, and a trade skirmish between the two largest economies in the world
âThe chart shows the market value of all publicly traded securities as a percentage of the countryâs business-that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.â Warren Buffett, 2011
âIt isnât how much you make but how much you keep.â Most investors grasp that concept when it comes to their own finances, but we also consider how it applies to the companies we own. Profit Margin is a percentage representation of how much of a companyâs sales they keep after expenses. Steady increases in margins over the past two decades have been allowing earnings to grow much faster than sales and played a significant role in pushing share prices higher. For a variety of reasons, margins have historically gone through cycles of expanding and contracting. We believe the long-term tailwind afforded stocks from expanding profit margins may be at risk of flipping into reverse.
The S&P 500âs forecast first-quarter profit marginâor earnings as a share of salesâis 10.7%, according to FactSet. While down nearly a percentage point from a year earlier, that would, with the exception of 2018, still count as a record high. The decade's long increase in profit margins was the result of many things going right at once, laborâs bargaining power fell, corporate taxes fell, tariffs fell, globalization increased, technology allowed for greater scale and lower marginal costs, anti-trust enforcement fell, and interest rates fell. These factors have produced one of the most pro-corporate environments in history.
Many of these trends seem at risk to at least partially reverse themselves in the years ahead. Incentives for offshore production have been reduced as global labor costs have increased and tariffs have been applied. Labor costs were also held down by the high unemployment rates after the great recession but are now trending upward. A trade war has resulted in supply chain disruptions. Corporate debt has increased, and interest rates have been rising. At the same time, we are in the midst of a populist backlash against rising inequality. Democrats vying for their partyâs 2020 presidential nomination view it as a hot-button issue, proposals to combat it through higher taxes and other redistributive policies are gathering momentum. Recent surveys show increasing animosity toward globalization and the power of companies more broadly and some welcoming attitudes toward government regulation of firms. There is also discussion about taxing mega-profitable firms that have benefited from current policies. For example, Europeâs potential âdigital services taxâ may be an indication of a turning tide. Of course, the trends may not continue, but if they do a material effect on corporate profit margins is coming.
By paying current prices for stocks, investors are assuming that not only valuations but also profit margins will remain near record highs indefinitely. If profit margins were to revert at the same time as valuations, it would mean a far more substantial decline than if only one factor normalized. It works like this: trailing earnings for the S&P 500 are currently $130. Valued with a multiple of 15x, which is roughly the long-term average, you get a price of 1,950 for the index or 28% below the indexâs current level. That would hurt, but it really would not be so bad relative to the bear markets of the recent past (think 2000 and 2008). However, if profit margins were to fall from 10% today to 6%, tomorrow earnings would fall to just $78. With a valuation multiple of 15x based on those lower earnings, youâre looking at 1,170 on the index or more than 50% below its current level. The table to the right shows some historical high and low points for corporate profit margins illustrating their historical fluctuation.
While not an exact match to this previous illustration, the chart below provides an example of what US stock values would be if profit margins had remained flat
Legendary investor Ben Graham preached the value of demanding a âmargin of safetyâ when investing in equities. Bob Prince of Bridgewater, the largest hedge fund in the world, recently said, âYouâve got a whole series of forces that are turning against corporations and profit margins. So your bigger risk is actually probably in the financial markets, rather than in the real economy.â Ray Dalio, also of Bridgewater, states, âignoring historical cycles is the No. 1 miscalculation many investors make.â In other words, ignoring how profit margins and valuations can rise and fall is a danger to investors.
We think that assuming both valuations and margins will maintain themselves at record levels indefinitely, is to engage in what could be called yet another speculative mania. The last time valuations were as high as they are today was at the height of the dot-com bubble. Back then, investors were making heroic assumptions about the prospects for growth in corporate sales and earnings. While we donât see the sort of euphoria we saw at the peak of the dot-com mania; we do see some investors making heroic assumptions about the sustainability of corporate profit margins and valuations, even if theyâre not conscious of doing so.
Itâs important to note that we consider many valuation measures. Those which focus on corporate earnings without consideration of profit margins still show the stock market to be somewhat expensive, though they suggest the over-valuation is less extreme. On the other hand, valuation measures which account for profit margins, such as the Buffett Yardstick shown in the Market Temperature section, are near all-time highs.
We feel the sum of the evidence concerning the risk level of markets encourages us to proceed with caution. We lean toward the view that a group of factors will converge to negatively impact profit margins in the future. This has resulted in our making short-term shifts with portions of your portfolio to be more conservative. However, since we donât know for sure when, or even if, these potential changes will occur, we remain vigilant and are prepared to adjust if factors prove our concerns are unwarranted.
If you have thoughts or questions about any of the information weâve shared, or on any other subject, please donât hesitate to call us. We are grateful you allow us to serve you and your family, and we will continue to make every effort to justify the trust youâve bestowed on us.
Your CCA Investment Team
Advisory services offered through Cravens & Company Advisors, LLC, an SEC Registered Investment Advisory Company. Securities offered through, and advisory services may also be offered through, FSC Securities Corporation, an Independent Registered Broker/Dealer. Member FINRA/SIPC and a Registered Investment Advisor. Not affiliated with Cravens & Company Advisors, LLC.
Investing involves risk including the potential loss of principal. Investing involves risk including the potential loss of principal. International investing involves additional risks including risks associated with foreign currency, limited liquidity, government regulation, and the possibility of substantial volatility due to adverse political, economic and other developments. The two main risks associated with fixed income investing are interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risks refer to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in commodities may entail significant risks and can be significantly affected by events such as variations in the commodities markets, weather, disease, embargoes, international, political, and economic developments, the success of exploration projects, tax, and other government regulations, as well as other factors. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of FSC Securities Corporation. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis do not represent the actual or expected future performance of any investment product.